The short answer is both simple and surprising: in many cases, lowering the rent on a building will force the bank to foreclose on it.

Foreclosure is very bad for both the bank and the operator, so both parties would rather “extend and pretend,” leaving the building vacant while they wait and hope for the market to change.

This seems absurd. Surely everyone would be better off it they just lowered the rent and got some use out of the building — getting some rent must be better than getting no rent, right?

Intuition fails because normal people think of a building as a building, when in the majority of cases, a building is not a building, but a financial product. Behavior that makes no sense for buildings can make perfect sense for a financial product.

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The important thing to understand here is that the actual building is not an important part of the value calculation. We’re not really looking at the replacement cost, the unique design, the amenities, the location, etc. Those things influence the assumptions about the gross rent we can get, or the cost of operating the building (higher cost means less net rent), but at the end of the day it isn’t the building that has value, it’s the income stream.

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Remember, the building isn’t a building, it’s an income stream. Before, the operator and the bank had a model that said the operator would be able to make $1M per year. Now, reality has proven the operator can only make $700k per year.

700k per year is not worth $20M. Given our agreed-upon cap rate of 5%, this proven $700k per year income stream is only worth $700k/0.5 =$14M.

In this scenario, the building has proven to only be worth $14M, but the operator owes $16M to the bank, so he is now $2M underwater on the loan. In two more years he’ll have to pay off the full $16M, and he doesn’t have that much cash, so he’ll need to refinance.

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When year five rolls around and the loan on the building comes due, both the original bank and the owner would like to avoid losing a combined $6M. And so long as the operator can afford to keep losing $140k per year on the building… they can!

What they need to do is stick to the original model. Don’t lower the rent. Just claim that there was a blip in the market, nobody could have seen that coming, it’s all going to be fine.

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The only sticking point here is that the building operator is still losing $140k per year. But remember that if he gives up, he loses the $4M he’s already put into the building. Even if he ended up paying $140k per year for 10 years before things turned around, losing $1.4M is still better than losing $4M.

So both the operator and the bank have a lot of incentive to extend and pretend, rather than lower the rent and face the consequences of having overpaid for the building.